Principles of Finance, 6e
Besley/Brigham
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a.
5.23 years
b.
4.86 years
c.
4.00 years
d.
6.12 years
e.
4.35 years
ANSWER:
b
RATIONALE:
Note: MACRS accelerated depreciation rates should be given for some of these
problems. These rates are provided in the text and on the formula pages.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Payback Period
48. You have recently accepted a one year employment term by a firm. The firm has given you the option of receiving
your salary as a lump sum value of $30,000 at the end of the year or as 12 monthly payments of $2,400 starting one month
after you start work. If your relevant discount rate is 2 percent per month, then which salary options would you prefer?
(Ignore taxes, risk, and consumption needs.) Choose the best answer.
a.
The lump sum payment, since it has the larger future value.
b.
Monthly payments, since you do not have to wait so long to receive your money.
c.
Either one, since they have the same present value.
d.
The lump sum payment, since it has the larger present value.
e.
Monthly payments, since it has the larger present value.
ANSWER:
e
RATIONALE:
Note: MACRS accelerated depreciation rates should be given for some of these
problems. These rates are provided in the text and on the formula pages. Equation
solution: Monthly option
Annual option Financial calculator solution:
Monthly payments Inputs: N = 12; I = 2; PMT = 2,400. Output: PV = −25,380.82 ≈
$25,381. Annual payment Inputs: N = 12; I = 2; FV = 30,000. Output: PV = −23,654.80 ≈
$23,655. Cash flow time line:
Principles of Finance, 6e
Besley/Brigham
Chapter 13
Time Estimate-a – 5 min.
TOPICS:
NPV Analysis
a.
Yes, because the IRR < the required rate of return (r).
b.
Yes, because the NPV = $30,000.
c.
Yes, because the NPV = $10,000.
d.
No, because r > IRR.
2
15,625
0
3
15,625
0
4
15,625
0
5
15,625
99,500
If the required rate of return on these projects is 10 percent, which would be chosen and why?
a.
Project B because of higher NPV.
b.
Project B because of higher IRR.
c.
Project A because of higher NPV.
d.
Project A because of higher IRR.
e.
Neither, because both have IRRs less than the required return.
ANSWER:
a
RATIONALE:
Cash flow time line: Equation
solution:
NPVB > NPVA; $11,779.55 > $9,231.25;
Choose Project B. Financial calculator solution: Project A Inputs: N = 5; I = 10; PMT =
15,625. Output: PV = −59,231.04. NPVA = $59,231.04 − $50,000 = $9,231.04. Project B
Inputs: N = 5; I = 10; FV = 99,500. Output: PV = −61,781.67. NPVB = $61,781.67 −
$50,000 = $11,781.67. Alternate method by cash flows Project A Inputs: CF0 = −50,000;
CF1 = 15,625; Nj = 5; I = 10. Output: NPV = $9,231.04. Project B Inputs: CF0 = −50,000;
CF1 = 0; Nj = 4; CF2 = 99,500; I = 10. Output: NPV = $11,781.67.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
Principles of Finance, 6e
Besley/Brigham
Chapter 13
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e.
No, because NPV < 0.
ANSWER:
c
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-03 – Capital Budgeting and Cost of Capital
DISC-FIN-08 – Risk and Return
Time Estimate-a – 5 min.
TOPICS:
NPV Analysis
52. The capital budgeting director of Sparrow Corporation is evaluating a project which costs $200,000, is expected to last
for 10 years and produce after-tax cash flows, including depreciation, of $44,503 per year. If the firm’s required rate of
return is 14 percent and its tax rate is 40 percent, what is the project’s IRR?
a.
8%
b.
14%
c.
18%
d.
−5%
e.
12%
ANSWER:
c
RATIONALE:
Financial calculator solution: Inputs: CF0 = −200,000; CF1 = 44,503; Nj = 10. Output: IRR
= 18%.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-03 – Capital Budgeting and Cost of Capital
DISC-FIN-08 – Risk and Return
Time Estimate-a – 5 min.
TOPICS:
IRR
53. An insurance firm agrees to pay you $3,310 at the end of 20 years if you pay premiums of $100 per year at the end of
each year of the 20 years. Find the internal rate of return to the nearest whole percentage point.
a.
9%
b.
7%
c.
5%
d.
3%
e.
11%
ANSWER:
c
RATIONALE:
Financial calculator solution: Inputs: CF0 = 0; CF1 = −100; Nj = 19; CF2 = 3,210. Output:
IRR = 5.0%. Alternate method annuity calculation Inputs: N = 20; PMT = −100; FV =
3,310. Output: I = 5.0%.
POINTS:
1
DIFFICULTY:
Easy
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© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
distributed with a certain product or service or otherwise on a password-protected website for classroom use.
54. The Target Copy Company is contemplating the replacement of its old printing machine with a new model costing
$60,000. The old machine, which originally cost $40,000, has 6 years of expected life remaining and a current book value
of $30,000 versus a current market value of $24,000. Target’s corporate tax rate is 40 percent. If Target sells the old
machine at market value, what is the initial investment outlay (after-tax) for the new printing machine?
a.
−$22,180
b.
−$30,000
c.
−$33,600
d.
−$36,000
e.
−$40,000
ANSWER:
c
RATIONALE:
Initial investment outlay
Cost of new machine
−$60,000
Salvage value (old)
+ 24,000
Tax effect of sale = $6,000(0.4) =
+ 2,400
After-tax outlay =
−$33,600
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-03 – Capital Budgeting and Cost of Capital
DISC-FIN-08 – Risk and Return
Time Estimate-a – 5 min.
TOPICS:
Investment Outlay
55. Carolina Insurance Company, an all-equity life insurance firm, is considering the purchase of a fire insurance
company. If the purchase is made, Carolina will be 50 percent larger than before. Currently, Carolina’s stock has a beta of
1.2 and the return required is 15.2 percent. The fire insurance company is expected to generate a return of 20 percent with
a beta of 2.5. If the risk-free rate is 8 percent and the market risk premium is 6 percent, should Carolina make the
investment?
a.
No; the expected return is less than the required return.
b.
No; the IRR is less than the appropriate required rate of return.
c.
Yes; the IRR is greater than the appropriate required rate of return.
d.
Yes; the expected return is greater than the required return.
e.
Yes; the project’s risk/return combination lies above the SML.
ANSWER:
a
RATIONALE:
Calculate the required return, rs, and compare to the expected return, . = 20%. rs =
TOPICS:
IRR
Principles of Finance, 6e
Besley/Brigham
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© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license
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0.08 + (0.06)2.5 = 0.23 = 23%. rs > ; 23% > 20%; reject the investment.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-03 – Capital Budgeting and Cost of Capital
DISC-FIN-08 – Risk and Return
Time Estimate-a – 5 min.
TOPICS:
Required Rate of Return
56. Louisiana Enterprises, an all-equity firm, is considering a new capital investment. Analysis has indicated that the
proposed investment has a beta of 0.5 and will generate an expected return of 7 percent. The firm currently has a required
return of 10.75 percent and a beta of 1.25. The investment, if undertaken, will double the firm’s total assets. If rRF = 7
percent and the market return is 10 percent, should the firm undertake the investment? (Choose the best answer.)
a.
Yes; the expected return of the asset (7%) exceeds the required return (6.5%).
b.
Yes; the beta of the asset will reduce the risk of the firm.
c.
No; the expected return of the asset (7%) is less than the required return (8.5%).
d.
No; the risk of the asset (beta) will increase the firm’s beta.
e.
No; the expected return of the asset is less than the firm‘s required return, which is 10.75%.
ANSWER:
c
RATIONALE:
Calculate the required return, rs, and compare to the expected return, . = 7%. rs = rRF
+ (rM − rRF)β = 0.07 + (0.10 − 0.07)0.5 = 0.085 = 8.5%. rs > ; 8.5% > 7.0%; reject the
investment.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-03 – Capital Budgeting and Cost of Capital
DISC-FIN-08 – Risk and Return
Time Estimate-a – 5 min.
TOPICS:
Required Rate of Return
57. Michigan Mattress Company is considering the purchase of land and the construction of a new plant. The land, which
would be bought immediately (at t = 0), has a cost of $100,000 and the building, which would be erected at the end of the
first year (t = 1), would cost $500,000. It is estimated that the firm’s after-tax cash flow will be increased by $100,000
starting at the end of the second year, and that this incremental flow would increase at a 10 percent rate annually over the
next 10 years. What is the approximate payback period?
a.
2 years
b.
4 years
c.
6 years
d.
8 years
e.
10 years
ANSWER:
c
POINTS:
1
Principles of Finance, 6e
Besley/Brigham
Chapter 13
Principles of Finance, 6e
Besley/Brigham
Chapter 13
4
1,938
417
If the required rate of return for Phoenix Products is 5 percent, which of the following is the most valid statement?
a.
The NPVA < NPVB, therefore accept Machine B.
b.
The NPVA > NPVB, therefore accept Machine A.
c.
The IRRA > IRRB, therefore accept Machine A.
d.
The IRRA < IRRB, therefore accept Machine B.
e.
Take neither A nor B since the required rate of return is greater than the internal rate of return
ANSWER:
b
RATIONALE:
Equation solution:
Therefore, accept Machine A since
NPVA > NPVB. Financial calculator solution: Using cash flows, Project A Inputs: CF0 =
−1,000; CF1 = 0; Nj = 3; CF2 = 1,938; I = 5. Output: NPV = $594.397. Project B Inputs:
CF0 = −1,000; CF1 = 417; Nj = 4; I = 5. Output: NPV = $478.661.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-03 – Capital Budgeting and Cost of Capital
DISC-FIN-08 – Risk and Return
Time Estimate-a – 5 min.
TOPICS:
NPV Analysis
61. You are considering the purchase of an investment that would pay you $5,000 per year for Years 1−5, $3,000 per year
for Years 6−8, and $2,000 per year for Years 9 and 10. If you require a 14 percent rate of return, and the cash flows occur
at the end of each year, then how much should you be willing to pay for this investment?
a.
$15,819.27
b.
$21,937.26
c.
$32,415.85
d.
$38,000.00
e.
$52,815.71
ANSWER:
b
RATIONALE:
Cash flow time line: (In thousands)
Principles of Finance, 6e
Besley/Brigham
Chapter 13
c.
Indifferent, because the projects have equal IRRs.
d.
Include both in the capital budget, since the sum of the cash inflows exceeds the initial investment in both
task of choosing one of the machines. Cash flow analysis indicates the following:
Year
Machine A
Machine B
0
−$2,000
−$2,000
1
0
832
2
0
832
3
0
832
4
3,877
832
What is the internal rate of return for each machine?
a.
IRRA = 16%; IRRB = 20%
b.
IRRA = 24%; IRRB = 20%
c.
IRRA = 18%; IRRB = 16%
d.
IRRA = 18%; IRRB = 24%
e.
IRRA = 24%; IRRB = 26%
ANSWER:
d
RATIONALE:
Cash flow time line: Financial calculator
solution: Machine A Inputs: CF0 = −2,000; CF1 = 0; Nj = 3; CF2 = 3877. Output: IRR =
17.996% ≈ 18%. Machine B Inputs: CF0 = −2,000; CF1 = 832; Nj = 4. Output: IRR =
24.01% ≈ 24%.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
IRR
64. Two projects being considered by a firm are mutually exclusive and have the following projected cash flows:
Year
Project A
Project B
0
($100,000)
($100,000)
1
39,500
0
2
39,500
0
3
39,500
133,000
Based only on the information given, which of the two projects would be preferred, and why?
a.
Project A, because it has a shorter payback period.
b.
Project B, because it has a higher IRR.
Principles of Finance, 6e
Besley/Brigham
Chapter 13
cases.
e.
Choose neither, since their NPVs are negative.
ANSWER:
b
RATIONALE:
[MACRS table required] Cash flow time line:
The firm’s required rate of
return is not given in the problem; use IRR decision rule. Since IRRB > IRRA, Project B is
preferred. Financial calculator solution: Project A: Inputs: CF0 = −100,000; CF1 = 39,500;
Nj = 3. Output: IRRA = 8.992% ≈ 9.0%. Project B: Inputs: CF0 = −100,000; CF1 = 0; Nj =
2; CF2 = 133,000. Output: IRRB = 9.972% ≈ 10.0%.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Mutually Exclusive Projects
65. Given the following information, calculate the NPV of a proposed project: Cost = $4,000; estimated life = 3 years;
initial decrease in accounts receivable = $1000, which must be restored at the end of the project’s life; estimated salvage
value = $1,000; net income before taxes and depreciation = $2,000 per year; method of depreciation = MACRS; tax rate =
40 percent; required rate of return = 18 percent.
a.
$1,137
b.
−$151
c.
$137
d.
$804
e.
$544
ANSWER:
e
RATIONALE:
[MACRS table required] Cash flow time line:
Project analysis worksheet:
I
Initial investment outlay
Principles of Finance, 6e
Besley/Brigham
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machine is installed, but required working capital will return to the original level when the machine is sold after 5 years.
Mars’ marginal tax rate is 40 percent, and it uses a 12 percent required rate of return to evaluate projects of this nature. If
the machine costs $60,000, what is the NPV of the project?
a.
−$15,394
b.
−$14,093
c.
−$58,512
d.
−$21,493
e.
−$46,901
ANSWER:
d
RATIONALE:
Cash flow time line: Depreciation cash
flows:
Year
MACRS
Percent
Depreciable
Basis
Annual
Depreciation
1
0.20
$60,000
$12,000
2
0.32
60,000
19,200
3
0.19
60,000
11,400
4
0.12
60,000
7,200
5
0.11
60,000
6,600
6
0.06
60,000
3,600
$60,000
Project analysis worksheet:
I
Initial investment outlay
1)
Machine cost
($60,000)
2)
Decrease in
NWC
15,000
3)
Total net inv.
($45,000)
II
Supplemental operating cash flows
Year:
0
1
2
3
4
5
4)
Reduction in
cost
$ 5,000
$ 5,000
$ 5,000
$5,000
$ 5,000
5)
After-tax dec. in
cost
3,000
3,000
3,000
3,000
3,000
6)
Deprec. (from
table)
12,000
19,200
11,400
7,200
6,600
7)
Tax savings
deprec.
(line 6 × 0.4)
4,800
7,680
4,560
2,880
2,640
8)
Net operating
CFs
(line 5 + 7)
$ 7,800
$10,680
$ 7,560
$5,880
$ 5,640
III
Terminal CF
9)
Estimated
salvage value
$10,000
10)
Tax on salvage
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Besley/Brigham
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in cost (line 6 ×
0.4)
3,000
3,000
3,000
3,000
3,000
8)
Deprec. (from
table)
8,000
12,800
7,600
4,800
4,400
9)
Deprec. tax
savings
(line 8 × 0.4)
3,200
5,120
3,040
1,920
1,760
10)
Net operating
CFs
(line 5 + 7 + 9)
$9,800
$11,720
$9,640
$8,520
$ 8,360
III
Terminal CF
11)
Estimated
salvage value
$10,000
12)
Tax on salvage
value
(10,000 −
2,400)(0.4)
(3,040)
13)
Return of NWC
—
14)
Net CF
6,960
IV
Net CFs
15)
Total Net CFs
($40,000)
$9,800
$11,720
$9,640
$8,520
$15,320
Equation solution:
Financial calculator solution: Inputs: CF0 = −40,000; CF1 = 9,800; CF2 = 11,720; CF3 =
9,640; CF4 = 8,520; CF5 = 15,320; I = 9. Output: NPV = $2,291.90 ≈ $2,292.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
New Project NPV
69. Given the following information, what is the required cash outflow associated with the acquisition of a new machine;
that is, in a project analysis, what is the initial investment outlay at t = 0?
Purchase price of new machine
$8,000
Installation charge
2,000
Market value of old machine
2,000
Book value of old machine
1,000
Inventory decrease if new machine is installed
1,000
Accounts payable increase if new machine is installed
500
Tax rate
34%
Required rate of return
15%
a.
−$8,980
Principles of Finance, 6e
Besley/Brigham
Chapter 13
POINTS:
1
b.
−$6,460
c.
−$5,200
d.
−$6,840
e.
−$12,020
ANSWER:
d
RATIONALE:
Cost plus installation
($10,000)
Sale of old machine
2,000
Tax effect of sale (1,000 × 0.34)
340
Decrease in working capital
1,500
Total initial investment at t = 0
($ 6,840)
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-2 – Application
Business Program-3 – Analytic
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Replacement Initial Investment Outlay
70. An all-equity firm is analyzing a potential project which will require an initial, after-tax cash outlay of $50,000 and
after-tax cash inflows of $6,000 per year for 10 years. In addition, this project will have an after-tax salvage value of
$10,000 at the end of Year 10. If the risk-free rate is 6 percent, the return on an average stock is 10 percent, and the beta
of this project is 1.50, then what is the project’s NPV?
a.
$13,210
b.
$4,905
c.
$7,121
d.
−$6,158
e.
−$12,879
ANSWER:
e
RATIONALE:
Cash flow time line: rProject = 6% +
4%(1.5) = 12%. Equation solution:
